ASC 606-10-25-30: Identifying Performance Obligations

The Financial Accounting Standards Board (FASB) established a framework for revenue recognition under Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers. This standard provides a unified approach for companies to recognize revenue in a way that depicts the transfer of promised goods or services to customers. A primary part of this framework is correctly identifying the promises made to a customer, with specific guidance found in ASC 606-10-25.

This guidance is applied after an entity has identified the promises within a customer contract. It provides the structure for assessing whether those promises are distinct and should be accounted for separately. The proper application of this guidance directly influences the timing and measurement of revenue, and misapplication can lead to material misstatements in financial reporting.

The Core Principle of Distinct Goods or Services

A “performance obligation” is a promise within a contract to transfer a good or service to a customer. These promises can be explicitly stated in the contract or implied by a company’s customary business practices. The identification of these obligations is the second step in the five-step revenue recognition model and forms the basis for how revenue is recorded.

A promised good or service gives rise to a performance obligation only if it is “distinct.” If a good or service is not distinct, it must be combined with other promises in the contract until a distinct bundle is identified. This bundling process ensures that the revenue recognized reflects the integrated deliverable the customer is receiving.

To be considered distinct, a good or service must meet two specific criteria. First, the good or service must be “capable of being distinct.” Second, the promise to transfer it must be “distinct within the context of the contract.” Both criteria must be satisfied for a promise to be accounted for as a separate performance obligation.

Criterion One Capable of Being Distinct

The first criterion for a good or service to be distinct is that it must be “capable of being distinct.” This assessment focuses on whether the customer can benefit from the good or service on its own or in conjunction with other resources that are readily available to them. The analysis determines if the individual good or service has standalone economic value to the customer. An indicator is whether the item can be used, consumed, or sold for an amount greater than its scrap value.

A customer can benefit from a good or service “on its own” if it provides economic utility without needing any other undelivered items from the same contract. For example, if a company sells a standard software license, the customer can use that software immediately upon receipt. The fact that the company may also sell training services in the same contract does not diminish the standalone functionality of the software itself. An indicator that this criterion is met is if the entity regularly sells the good or service separately.

The analysis extends to considering “readily available resources.” These are goods or services sold separately by the selling entity or another company, or resources the customer has already obtained. For instance, a company sells a specialized piece of medical equipment that requires a common, standardized type of disposable cartridge to function. If these cartridges are sold by numerous other suppliers, they are considered readily available resources, and the equipment would be deemed capable of being distinct. In contrast, if the equipment requires a proprietary cartridge sold only by the same company under the same contract, the equipment would not be capable of being distinct on its own.

Criterion Two Distinct within the Context of the Contract

Meeting the first criterion is not sufficient; the promise must also be “distinct within the context of the contract.” This second criterion requires an evaluation of whether the promise to transfer a good or service is “separately identifiable” from other promises in the contract. The objective is to determine if the nature of the promise is to transfer individual items or to transfer a combined, integrated item for which the individual components are merely inputs.

The standard provides three factors that indicate two or more promises are not separately identifiable and should be bundled into a single performance obligation. The presence of one or more of these factors suggests that the individual goods or services are not distinct in the context of the arrangement. These indicators help assess whether the promises are intertwined.

A primary indicator that promises are not separately identifiable is when the entity provides a service of integrating the goods or services into a combined output. This often occurs in construction or complex installation contracts where the entity is responsible for making various inputs work together to deliver the final product. For example, a contractor building a hospital is providing materials and services. While each of these could be sold separately, the contractor’s main promise is to integrate them into a functional building, making the entire project a single performance obligation.

Another indicator is when a good or service significantly modifies or customizes another good or service promised in the contract. Consider a company that sells off-the-shelf software and also provides a service to heavily customize the software’s code to integrate with the customer’s proprietary systems. The customer cannot benefit from the customization service without the software, and the standard software is significantly altered by the service. In this scenario, the software and the customization service are inputs to a single, combined, customized software system.

Finally, promises are not separately identifiable if the goods or services are highly interdependent or highly interrelated. This means one good or service cannot be used without the other, or its utility is significantly impacted by the other. For instance, a contract to design and manufacture a new, highly complex satellite involves two promises. The design is specific to the satellite, and the satellite cannot be built without the unique design. The two promises are so closely linked that the entity is fulfilling a single promise to deliver a functioning satellite.

Application and Documentation of the Analysis

Applying the criteria for distinct performance obligations requires a systematic approach. The analysis begins at contract inception, where an entity must identify all explicit and implicit promises of goods or services in the agreement. This involves a thorough review of the contract terms and any customary business practices. Once all promises are identified, each one must be evaluated against the two-part test for being distinct.

The first stage of the evaluation assesses each promised good or service against the first criterion: whether it is capable of being distinct. Promises that fail this test are immediately bundled with other promises until a bundle is created that is capable of being distinct. Promises that pass this initial test move to the next stage of analysis.

The second stage subjects the promises that are capable of being distinct to the second criterion: whether they are distinct within the context of the contract. This requires analyzing the relationships between the promises, using the three indicators of integration, modification, and interdependence as a guide. If the promises are determined to be separately identifiable, they are treated as individual performance obligations; if not, they must be combined.

Documenting these judgments is a requirement for compliance and auditing purposes. The documentation should create a clear trail of the analysis performed. It should list all identified promises from the contract and provide a specific rationale for how each promise was assessed. This includes referencing the specific facts and circumstances, such as whether an item is sold separately or the nature of any integration services, that support the conclusion. The final documentation should clearly state the identified performance obligations for the contract.